Pick up a text book on corporate finance and you will run right into the discounted cash flow valuation method. It is so important that it usually deserves a chapter on its own. Students sweat it, professors hammer in the fundamentals, professionals remember the bruising experience studying the DCF method for years afterwards.
So what’s the attraction, you ask? The magic of the discounted cash flow valuation is that it lets you figure out the value of a business based on the two most important factors: risk and return.
Discounted cash flow nitty gritty: earnings forecast and discount rate build up
You forecast the business earnings and expenses and estimate the cash flows for several years going forward. You then assess business risk and come up with the discount rate. Then it’s time to plug these inputs into the DCF calculation. Voila, your business valuation is ready, translating the future expectation into the present day dollars. Magic, indeed.
But wait, there is more. The DCF formula looks like an infinite sum in the making. Pay close attention and you will see that the forecast of cash flows is discounted year after year. When does one stop forecasting exactly?
Well, mathematically speaking, you could go on forecasting forever. The sum is theoretically infinite and discounting seemingly never ends.
Closing the discounted cash flow model
In the real world, it does not work quite like that. Unless you have a crystal ball, you can forecast business earnings only so far into the future. Beyond a certain point in time, it’s anyone’s guess. Think about it. Could you accurately predict the Great Depression coming, or even the Great Recession for that matter?
Markets have a tendency of throwing curve balls once in a while, limiting your ability to predict business performance a long way out.
Terminal value – the leap of faith in the discounted cash flow valuation
That’s where the second part of the discounted cash flow model comes in: the so-called terminal value. It closes the calculation by letting you stop the cash flow forecast only a few years into the future. You then shut your eyes for a moment and make a leap of faith: business earnings should grow at a constant rate forever.
That’s a typical assumption made by all financial analysts for going concern businesses. You basically create a cash flow forecast for as long as you can reasonably estimate it. After that time, you close the DCF calculation by appending the terminal value to the discounted forecast. The sum of the two is the business valuation result.
Having trouble with the terminal value? The devil in the details.
Sometimes the terminal value part causes trouble. It just seems way too large, skewing the valuation result. What could be the problem here?
As is usual in business valuation, the devil is in the details. Take a closer look at the formula for terminal value. You have a fraction with the numerator being the product of the last cash flow in your forecast times a term including the expected earnings growth rate. This growth rate is again used in the denominator to capitalize the terminal value result.
The culprit – overstated earnings growth rate
One way this calculation can yield a big number is if your cash flow forecast is too high. More often, the calculation produces surprises when the long term earnings growth is overestimated. This gives you a tiny number for the capitalization rate. Bingo, the resulting terminal value goes through the roof!
The moral of the story is whenever you doubt your valuation results, check your assumptions. As the saying goes, garbage in, garbage out.